Personal Finance For Young Professionals

One of the most valuable classes at Cal that I attended was not an engineering class, nor was it technical. It was UGBA 196, Personal Financial Management. Professor Selinger seared into our brain about “the magic of compounding” and how it is ever so important that managing your personal finance while you are still young will reap benefits orders of magnitudes higher than if you started later.

I’m writing this guide because ever since I took that class, I have learned how important it is to understand personal finance, and that especially for young working professionals, it is extremely important to start saving correctly right now. I am not claiming to be an expert (hardly one) in managing money, and you definitely should do your own research before doing anything. But I hope this is a guide that will help jump-start or help get you on track to managing your money right.

Magic of compounding

First step, think about retirement. My favorite retirement calculator is the AARP Retirement Calculator. It is the most simple and concise calculator to get you to start thinking about how much money you want to be saving in order to reach your goals when you retire. For me, it claims that I need a minimum of $2,827,254 to retire in the lifestyle that I want. However, based on my current savings trajectory (the amount I’ve saved so far and the amount I am saving on a monthly basis), I am estimated to have saved $6,420,432 by the time I retire. I sure hope that is true, I’ll check this article when I’m 67 to see if I actually met this target.

Look at that graph. You can see that saving early has its benefits of exponential growth (assuming the standard 6% rate of return on savings, 3% inflation, and no dot-com bubble), or for the programmers, it looks similar to a plot of O(n^2) time complexity for bubble sort (until you hit age 67, which is when you get wiser and bubble sort becomes easier). As you continue to reinvest the money and put the money that you earn back into the account, the money compounds, and that is what the magic of compounding is.

To give you a classic example, a fun question to ask a kid, “Would you rather have $10,000 per day for 30 days or a penny that doubled in value every day for 30 days?” Innocent and naive kids might choose the first option, but the correct answer is the latter option. The first option will net you $300,000 whereas the second option will net you over $5,000,000 dollars! Don’t believe me? Here is the breakdown:

Day 1: $.01 Day 2: $.02 Day 3: $.04 Day 4: $.08 Day 5: $.16 Day 6: $.32 Day 7: $.64 Day 8: $1.28 Day 9: $2.56 Day 10: $5.12 Day 11: $10.24 Day 12: $20.48 Day 13: $40.96 Day 14: $81.92 Day 15: $163.84 Day 16: $327.68 Day 17: $655.36 Day 18: $1,310.72 Day 19: $2,621.44 Day 20: $5,242.88 Day 21: $10,485.76 Day 22: $20,971.52 Day 23: $41,943.04 Day 24: $83,886.08 Day 25: $167,772.16 Day 26: $335,544.32 Day 27: $671,088.64 Day 28: $1,342,177.28 Day 29: $2,684,354.56 Day 30: $5,368,709.12

That is the magic of compounding. Time is on your side when you are young. Start saving now and see a greater return on your savings when you are older. When you are 70 years old and looking back, you can thank me for being able to retire on that private island of yours with your yacht (hopefully you’ll hook me up and let me join you).

Why is time important? Take this same example, but say little Jimmy procrastinated and decide to start 10 days late into the 30 day trial. What if you had the right idea, but decided to just start a little later? Here’s what happens, Jimmy experiences the same growth and numbers but he stops at day 20 (analogous to how we all will retire around the age of 65ish). Jimmy’s penny is now worth about 5 thousand dollars compared to the other guy who started early and managed to net 5 million dollars with the same exact penny but started 10 days earlier. Jimmy would be furious and regret that he didn’t take action earlier. Don’t let that happen to you, seriously start now and don’t be a Jimmy.

Are you convinced of the magic of compounding? Want to get started? Here is what I do and some tips and advice to get you started to a well deserved retirement.

Retirement

401k vs IRA

For retirement, you are usually looking at two options for where to store your money. The 401k and the IRA. Below, I’m going to talk about the differences and help you decide which one is better suited for you.

401k is a retirement investment vehicle provided by your employer, whereas an IRA is something you set up on your own. Does your company match what you put in to a 401k? For example, if your company matches $.40 for every dollar you put in, up to 6% of your salary, that is free money and you should absolutely be contributing to 401k. In this example, the optimal amount to contribute is exactly 6% of your salary. If you earn $70,000 annually, put $4,200 (70000 * .06) every year into your 401k and you’ll find that your company will contribute $1,680 (4200 * .40) of the company’s money for free to your account. 401k is the way to go if your company provides some sort of contribution matching. For 2013, the maximum that you can contribute to a 401k is $17,500.

If your company matches 401k, then you should definitely do it. If not, then you can choose between 401k and an IRA. IRA offers more flexibility in terms of the different options that you can invest your money in, such as stocks, mutual funds, and bonds. Do note that there are income limits which, if you exceed, you cannot contribute to an IRA. Assuming you are under age 49, then the maximum that you can contribute as of 2013 to an IRA is $5,500.

401k and IRAs are retirement accounts, which means if you withdraw before you are of age 59.5 you will be slapped with heavy penalties and taxes except in a few exceptions. IRAs are a little more lenient in that you can withdraw early for first time home purchases, education expenses, or certain medical expenses. However, for the sake of brevity, I won’t go too deep into the various rules and penalties. Just keep in mind that the money you contribute into a 401k or an IRA is money that you should not plan on touching until you are verrrry old. You can see the various penalties here.

401k if your company has a matching plan, IRA if your company doesn’t, because it is more flexible.

Traditional vs Roth

Both IRA and 401k offer a traditional and roth version, and many people get confused and tripped up on what the difference is. The difference is that traditional means you don’t pay taxes now, but when you withdraw from your account (when you are retired), and roth means you pay taxes now, but not when you withdraw. So do you want to pay taxes now, or later? For young folks, it’s been suggested that the roth type is the way to go because assumingly, you’re in the lowest tax bracket right now, so you should pay the tax now rather than later when you will be in a higher tax bracket in the future. Roth is a hedge against tax rates increasing in the future, whereas traditional is a hedge against tax rates decreasing in the future. So the optimal strategy would be to have a balance of roth and traditional accounts to hedge against both scenarios. I really enjoyed reading this article and particularly the table that shows you all the possible scenarios (increasing tax rates vs decreasing tax rates vs equal tax rates in the future). I prefer roth because the penalty for early withdrawals are not as severe and the income limits are higher.

Traditional means you pay taxes when you withdraw the money, roth means you pay taxes now, but get to withdraw tax-free. Have a good balance of both to be optimal.

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